Robert M. Dammon, Carnegie Mellon University
James Poterba, Massachusetts Institute of Technology
Chester S. Spatt, Carnegie Mellon University
Harold H. Zhang, University of Texas at Dallas

Choosing the right asset location for a pair of asset classes is more important when the tax rate differential between the two types of assets is greater and when the rate of return on the relevant assets is high.

The relative proportions of taxable and tax-deferred wealth are an important factor in determining one?s optimal asset allocation. According to the Samuelson award-winning authors, other factors being equal, an investor?s optimal equity allocation will be higher when a larger proportion of his/her total wealth is held in taxable accounts, and that his/her optimal bond allocation will be higher if the bulk of his/her wealth is held in tax-deferred accounts.

The ideal situation occurs when the desired asset allocation is reached by investing the entire tax deferred account in bonds and the entire taxable account in equities. More often, the proportions of financial assets don?t match up neatly with the desired asset allocations, and so adjustments may be needed. The authors state that for maximum tax efficiency, individuals should not hold mixed portfolios of equities and bonds in both their taxable and tax-deferred accounts

In this article, we “go back to basics,” but do so in the presence of taxes. There are but two assets: a stock fund and a bond fund. Each asset can be held in taxable accounts, deductible pension accounts, or both (deductible pension accounts include, e.g, 401(k), 403(b), Keogh, and SEP-IRA). An individual investor has some assets in taxable accounts and others in deductible pension accounts. He asks his financial professional to do three things. First, calculate the portfolio’s current asset allocation. Second, recommend an optimal asset allocation. Third, recommend an optimal asset location. More specifically, he asks whether he should, to the degree possible, locate locate stocks or bonds in tax-sheltered pension accounts.

William Reichenstein, Ph.D.,
TIAA-CREF Institute Fellow, Baylor University
February 2006

A central component of investment advice in recent decades both for individual and institutional investors has focused on asset allocation, and rightly so since it plays a critical role in determining returns. For individual investors, tax management also plays a significant role in maximizing wealth but it typically does not receive the attention it deserves. This Trends and Issues examines four types of tax considerations that can reap benefits to investors:

This study first explains why individuals should calculate an after-tax asset allocation. This asset allocation distinguishes between pretax funds in say a 401(k) and the generally after-tax funds in a taxable account. Separately, it performs mean-variance optimizations for individual investors. It concludes that, in general, almost all investors should locate bonds in Roth IRAs and qualified retirement accounts (e.g., 401(k)) and stocks, especially passively held stocks, in taxable accounts. At lower levels of risk tolerance, investors should substitute bonds held in non-qualified annuities for stocks held in taxable accounts. At higher levels of risk tolerance, they should substitute stocks for bonds held in Roth IRAs and qualified retirement accounts. The analysis suggests that the people who should be most interested in holding stocks in annuities are those who trade too frequently to qualify for preferential capital gain tax rates. Finally, this study may be the first to demonstrate that an individual investor bears more risk when an asset is held in an annuity instead of taxable account, and it considers the implications of this conclusion for optimal asset-allocation and asset-location decisions

Executive summary. It has long been understood that asset allocation, based on an investor’s goals, risk tolerance, and investment horizon, is one of the most important determinants of long-term portfolio performance. Proper diversification, low relative costs, and rebalancing are also critical to realizing the benefits of the selected asset allocation. Perhaps less understood is the impact of asset location. Asset location refers to where or in which type of account (taxable or tax-deferred) an investor should purchase stocks and bonds. After determining the appropriate asset allocation, the investor should decide whether the primary goal is to maximize after-tax return by forgoing tax-inefficient investments or strategies (for example, active equity mandates, real estate investment trusts [REITS], commodities, or other alternative investments) or to include these tax-inefficient assets or strategies in the hope of adding performance or reducing the portfolio’s risk.